How Does MTM Reduce Counterparty Risk in Derivatives Trading?

Marking-to-market significantly reduces counterparty risk by preventing the accumulation of large, unsecured debts between trading parties. Since profits and losses are settled in cash daily, any party facing a loss must immediately post collateral (margin) to cover that loss.

If a party defaults, the clearing house can use the posted margin to cover the obligations, ensuring the non-defaulting party receives their due funds. This daily settlement mechanism minimizes the potential size of any default loss.